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Stakes raised in chip ban

Going for the jugular: ZTE’s ability to manufacture smartphones will be hampered by US component ban

Chen Jin made a name for himself 15 years ago with the invention of the Hanxin computer chip, which means “the heart of Han [Chinese]”.

The domestic media was ecstatic about his homegrown processor, predicting that it would allow every Chinese to have a China-powered computer.

The Fujian native – who spent time in the United States and worked briefly at Motorola – achieved overnight hero status. The problem was that Chen, then dean of the micro-electronics school of Shanghai Jiaotong University, was found to be cheating. In 2006 investigators discovered that his chips were a fraud and that in some cases he had paid migrant workers to simply sand off the Motorola brand and replace it with the Hanxin logo.

The scandal was a major embarrassment for the government, which had provided financial backing for the project. But it also highlighted China’s desperation to see its semiconductor sector catch up with the West and reduce the country’s reliance on foreign technology.

The drive for a domestic chipmaking industry has accelerated since the Hanxin-1 debacle but China’s dependence on foreign brands still looked deadly this month, when the US government told ZTE, a leading telecommunications equipment company and smartphone maker from Shenzhen, that it wouldn’t be allowed to source components from American firms.

What’s the background to ZTE’s predicament?

Restrictions on the sale of American-made components to ZTE were first announced two years ago after it was charged with ignoring sanctions on sales to Iran and North Korea (see WiC317).

Enforcement of the action was delayed when the company pleaded guilty to the charges last March and agreed to pay a $1.2 billion fine (see WiC358).

Washington then put ZTE on a year’s probation but it emerged last week that it wasn’t happy with the company’s compliance. The result: a shock announcement that the embargo had been reinstated and that it will stay in place for seven years.

As part of the settlement, the company had agreed to dismiss four senior executives and discipline a larger group of staff by reducing their bonuses or reprimanding them. However, although the top executives were dismissed, ZTE took no action against the other employees. Wilbur Ross, the US Secretary of Commerce, says that it even paid some of them bonuses and that it has continued to lie to investigators since the settlement was agreed.

“Instead of reprimanding ZTE staff and senior management, ZTE rewarded them,” he said in the statement. “This egregious behaviour cannot be ignored.”

How badly will the ban hurt ZTE?

ZTE chairman Yin Yimin has admitted to the latest round of wrongdoing but has complained that the punishment is disproportionate to the crime. “Such sanctions could put the company immediately into a coma,” he argued in a press conference at the firm’s headquarters in Shenzhen last week.

ZTE also postponed the release of its quarterly earnings and suspended its shares from trading on the Shenzhen and Hong Kong bourses, saying it needed time to assess the impact of the ban.

Estimates vary but between 25% and 40% of the components ZTE needs for its products are purchased from US suppliers, including microchips, network products, operating systems and software. The ban means no chips from Qualcomm and no optical components from companies like Oclaro and Lumentum. Also at risk are new Android releases for its smartphones, including Google apps such as Gmail, Google Drive and YouTube.

The restrictions come at a time when ZTE was the only Chinese smartphone manufacturer reporting significant progress in the US market, selling nearly 19 million handsets there last year and becoming the fourth-largest vendor of handsets. Even more seriously, the measures will hit its sales of network equipment to telecom operators, businesses and public sector customers in more than 160 countries, which provide about 85% of its operating profit.

Chinese ambitions for leadership in 5G wireless technology also seem set for a hammering. ZTE is one of the pioneers in the sector. It has been showcasing a pre-5G smartphone powered by chips from Qualcomm and it was expected to be a key player in rolling out China’s 5G network by the end of the decade. Further afield it has signed strategic cooperation agreements for 5G trials with a range of companies including SoftBank (Japan), Orange (France), Telenet (Belgium), Wind Tre and Open Fiber (Italy), KT (South Korea) and Telefonica (Spain). What happens next is unclear. But the seven-year ban covers the critical period during which the next-generation standard is supposed to be implemented.

A wider clash with Washington, not just a complaint against ZTE?

Yin Yimin indicated this subtext in his statement, saying that ZTE opposed “such an unfair, unreasonable punishment, and especially the act of politicising trade issues”.

Trump’s administration will counter that the case pre-dates the latest round of tariffs and that the action is simply a punishment for violations of the terms of the original deal struck last year.

That won’t stop ZTE feeling that it has been targeted again – a frustration it has shared with Huawei since the publication of findings by the House of Representatives’ Intelligence Committee that both firms constituted a threat to American national interests (see WiC168).

ZTE complained at the time that it was unfair to single it out as a threat to US communications networks. “Virtually all of the telecom infrastructure equipment sold in the US and throughout the world contains components made – in whole, or in part – in China,” it pointed out.

A new study sponsored by the US-China Economic and Security Review Commission has just come to similar conclusions, sounding the alarm bell that much of the federal government’s annual $90 billion spend on information technology is dependent on Chinese products that could be exploited for snooping or cyber attacks.

The report, published this month, said that the main suppliers of computers, routers, software and printers to the federal administration rely on Chinese factories for many of their components and that 51% of parts shipped to firms like HP, IBM, Dell, Cisco, Microsoft and Intel originate in China.

What’s more, it warned that ZTE, Huawei and Lenovo are three “Chinese national champions” that could conduct corporate espionage in the US, and the risks will worsen as newer spending on internet-connected devices spreads through homes and offices, and as Chinese firms take on a greater role in the implementation of 5G standards. “Modernisation will actually increase risk if newly adopted technologies are not assessed appropriately,” it concludes.

And in a sign that things are worsening, the Wall Street Journal reported on Wednesday that the US Justice Department has also been investigating whether Huawei violated US sanctions in relation to Iran. If found guilty, Huawei might face a similar bar on buying US chips. Given Huawei’s status as one of China’s most prominent exporters that would trigger a meltdown in Sino-US relations.

Support for the home team…

ZTE’s predicament has got plenty of play in the local press and there were expressions of support on social media as well, including photos of a restaurant that was offering free meals to the company’s employees.

“If it were not because of ZTE’s strength and ability to represent China, it would not have been punished like this,” proclaimed the banner outside the eatery.

The government has been speaking up for the embattled manufacturer too, opposing the severity of the American embargo. “We hope the US does not try to be too clever, or it will only receive a bitter outcome from what it has done,” a spokesman from China’s commerce ministry suggested.

The Chinese government was relatively subdued in its responses to the initial fine for ZTE last year, probably because the Shenzhen firm was caught red-handed in breaching the sanctions on Iran and North Korea.

Now it finds itself having to defend the company once again. But an internal report said to have been compiled by Sasac, which manages some of the largest state-owned enterprises, leaked onto news portal Sina, laying bare the frustrations behind the scenes.

The authors described ZTE’s dealings with US regulators as “stupid and passive” and complained that bosses at the company had “taken risks to engage in illegal operations numerous times”.

“Many domestic enterprises are paying a terrible price for ZTE’s short-sightedness and dishonesty. Our country’s diplomatic layout and image will inevitably be affected,” the report concluded.

Are there any beneficiaries from the ban?

Early winners will be the brands that grab ZTE’s smartphone share in the US, mostly low-cost and mid-range handsets. Taiwanese suppliers may also get a boost as ZTE substitutes their components into its supply chain to replace American products.

Huawei – ZTE’s main rival in the Chinese market – isn’t (yet) subject to the same restrictions on American components and theoretically it could pick up more sales of communications equipment and handsets once ZTE’s deliveries start to be disrupted.

That isn’t likely to apply in the US, however, following reports that Huawei has pretty much given up on a breakthrough in American sales after AT&T and Verizon both pulled out of partnerships to sell its handsets earlier this year.

Tellingly, the New York Times reported last month that the Chinese giant has sacked five senior American employees, including the chief liaison officer responsible for government relations in Washington.

Li Changzhu, vice president of Huawei’s consumer group’s handsets strategy, is also said to have told the company’s annual analyst summit this month that Washington had effectively “locked the door” to keep the tech giant out.

What happens next?

Huawei is now number one for worldwide sales of telecoms networking equipment and number three in smartphone sales – rankings achieved without meaningful revenues from the American market.

Perhaps that points to a future in which other Chinese brands will prosper, despite restrictions on sales to US customers.

In the meantime ZTE has been scrambling for another stay of execution. Xinhua says the company has an inventory cycle of about two months, so there are a few weeks to potentially agree terms with US regulators before production grinds to a complete halt.

However, it took 10 months to negotiate the last deal and it is unclear whether ZTE can appeal again. New terms would also have to be approved by the agency that issued the initial ban.

“I never say never, we’re going to have to see how this unfolds. But there is no provision currently for that to occur,” an unnamed source at the US Commerce Department told Reuters.

In the longer term, the case will refocus Chinese efforts on establishing a supply chain beyond Washington’s reach. Yin tried to tap into this sentiment by promising to boost spending on research and development at ZTE, offering the maxim that “relying on oneself is better than relying on others”.

But the fear for Beijing’s policymakers is that other firms might face similar censure from beyond Chinese borders. Could tech giants such as Tencent or Xiaomi stray into the firing line in future, for instance? And what would happen to stalwarts in sectors like financial services, oil and gas, or carmaking if they provoked Washington’s wrath?

“They all rely, in some way or another, on technologies, components, software and intellectual properties from American companies like Apple, 3M, AMD, Applied Materials, Cisco, Corning, Google, Intel, Micron, Microsoft, Qualcomm, Seagate or Western Digital,” Jean Baptiste Su, an analyst at Atherton Research, told Forbes magazine this week.

“Although difficult to imagine, but not impossible at this current state of the US-China trade dispute, if the US decides to extend the technology ban to other – or all – Chinese firms, this could bring the entire Chinese economy to its knees.”

Jack Ma of Alibaba concurs, telling an audience at Japan’s Waseda University: “100% of the market for chips is controlled by the Americans. And suddenly if they stop selling – what that means, you understand. And that’s why China, Japan, and any country you need core technologies.”

This is a case of two countries on a collision course?

Predictions of a cataclysmic confrontation might sound dramatic but they tap into concerns first expressed by Chinese President Xi Jinping two years ago, when he called for reduced reliance on foreign tech (phrases from the very same speech were recycled in the Chinese press last week).

“Internet core technology is the greatest ‘vital gate’, and the fact that core technology is controlled by others is our greatest hidden danger,” the Chinese leader warned. “This can be compared to building a house on another person’s foundation: however large or beautiful it is, it might not stand the wind or the rain, or might even collapse at the first blow.”

The language may have been florid but the policy response has tried to be more forceful in supporting the creation of homegrown chipmakers.

Companies including Alibaba, Huawei and Xiaomi are already designing their own chipsets and domestic foundries have benefited from a state-backed Rmb140 billion fund ($22 billion) that has invested in about 20 listed companies (see WiC357).

For the Chinese press, the action against ZTE highlights that the plan should be a higher priority, and Xinhua and the People’s Daily both ran articles calling for faster development of the semiconductor sector.

The Global Times was also hankering for tech autarchy. “If a big portion of Chinese chip buyers support the development of domestic chips, then the development of domestic chips will be unstoppable,” it trumpeted.

However, as the South China Morning Post also reported this week, the Chinese challengers trail their American rivals by some distance, with US chip producers having at least 10 times the market value of China’s biggest listed chipmaker Shenzhen Huiding Technology. While the processors made by the US brands are commonly used in more upscale electronics, the Chinese are still scrambling for the lower-end market in products such as bankcards and USB-keys.

Hence some of the frustration on social media that the government isn’t doing more to bolster domestic chip making, and that short-termist local investors have been too focused on less important sectors of the economy.

“Bicycle sharing is burning hundreds of billions of yuan, but cutting-edge technology isn’t getting enough investment” was one of the complaints (see WiC404 for more on the bike-sharing boom).

The broader context is the “Made in China 2025″ initiative, which wants to create local champions in industries like information technology, renewable energy, electric vehicles, robotics and artificial intelligence (AI). The goal is for Chinese firms to diminish their dependency on foreign tech and strike out alone into newer, transformative industries. Yet efforts to implement the plan have embittered the Trump administration, which has justified its tariff campaign with complaints about unfair practices including state subsidies and forced tech transfer (see WiC402). The White House is also said to be considering using emergency laws that typically target rogue regimes to restrict further investment from Chinese firms in sensitive technologies, according to a briefing from a senior Treasury official to a conference in the US capital last week.

With both sides now positioning themselves for a technological arms race, one of the risks is that the Chinese feel pressured into a more confrontational response because they can’t afford to wait for the “Made in China 2025” programme to take full effect.

At an Asia Society discussion in Hong Kong this week Professor Graham Allison of the Harvard Kennedy School opined that American fears about being surpassed by China in the next technological revolution – one driven by AI and Big Data – were at the root of the current trade and tech disputes. “Expect things to get worse before they get worse,” quipped the author of Destined for War: Can America and China escape Thucydides Trap?

Speaking of the tensions arising from the ZTE situation, Allison referenced a remark he made to former National Security Advisor HR McMaster after returning from the China Development Forum last month: “If Thucydides were watching, he would say all the actors are right on script, moving inexorably towards the greatest collision in history.”

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